Bitcoin - A 'Bubble' and Little More

Reports about how IT worker, James Howells, was frantically searching a landfill site in Wales this week, having lost his hard drive containing over £4million worth of Bitcoins, capped a suitably ridiculous week of coverage and speculation about this latest monetary fad. One would hope that this marks the peak of an already frothy market.

No financial asset has received more press over the past year than Bitcoin. Any asset whose price has risen by 80fold in the past 12 months is going to get some exposure in the media and, consequently, will also grab the attention of anyone who is looking to make a quick return.

It's been quite a story, I'll give you that - Bitcoin was valued at $13 a unit at the beginning of the year and crossed the $1,000 barrier this week. Some have even suggested that it is a currency which will revolutionise the world of commerce. This is as fantastical as it comes.

Bitcoin is not a currency. Even during the dark days of 2008, as the world slid towards the abyss, the volatility of the world's currency markets were nothing compared to the day-to-day swings and lurches of the Bitcoin price. To say that something is a 'currency' means that it must exhibit certain characteristics as: 1) a medium of exchange, 2) an accounting unit and 3) a store of value. It is on the last two points here that the Bitcoin falls flat on its face.

If I owe you a debt of £700 I can, hypothetically, transfer you one Bitcoin and our debt is paid. The very next day, true to recent market movements, we then see a massive 20% shift in the price of Bitcoin and one of us has lost out. A 20% move higher will have seen you take on an asset worth a lot more than the original debt, and vice versa. The use of Bitcoin for commerce will always then be overshadowed by the opportunity cost of not waiting for it to tick higher and higher.

The essence of a large proportion of the pro-Bitcoin argument is that, via a tightly controlled money supply, inflation is eliminated. But instead we have got massive, self-imposed deflation.

There will come a point that the supply is choked off so much that Bitcoin can only increase in value, and with that will come hoarding. Simply put, why use these 'precious' assets for menial tasks, like buying a pizza or a beer, when you can keep them and only watch them increase in value?

I will take the inflation that we have in a truly transaction-able currency, like sterling, all day long compared to Bitcoin. And merchants will learn to do the same. Advertising that "Bitcoins are accepted here" will be a marketing tool and little else in the long run.

Of course, given these money supply dynamics and the expected increase in price, those who are sat on a significant holding of Bitcoins are currently loving life. Following a recent appearance on BBC Newsnight, during which I debated the relative pros and cons of "crypto-currencies", I have been beset by Bitcoin supporters as someone who is simply jealous of the gains that those who invested have seen. They're entitled to their opinion, but my scepticism is based on a genuine concern about the sustainability of this bubble.

The concept of manias has been studied throughout economic history and I believe Bitcoin to be nothing but the latest craze. The notion of "intrinsic value" is what is key here. Bitcoin advocates froth at the mouth about fiat money and the ability of central banks and governments to create cash from thin air. They say that this money is therefore backed by nothing, it has no worth. That is simply incorrect. The money is backed by the central bank, the government and, by extension, every person in that country via the means of democracy.

To say that currencies are fiat is to miss the most glaring error Bitcoin advocates continue to make; Bitcoin is in fact the most fiat of fiat currencies. It is backed by nothing other than what the market says it is worth.

At least gold and silver have industrial and commercial uses; Bitcoin is the chocolate fireguard of the financial world. Its value is entirely subjective. The value of legitimate currencies such as the pound, the dollar, the yen and everything else is objective. I'd know which one I'd rather have in my virtual pocket.